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Tax Efficient Mutual Funds

Mutual funds are among the most popular investment vehicles for investors. They are relatively simple to understand, the initial investment is usually small and they allow average investors to access some of the best professional money management in the world. Mutual funds are also easy to buy and sell and offer daily pricing.

However, most mutual funds are not tax efficient. I have had many conversations with investors who are caught unaware of the tax risks associated with most mutual funds. Many people learn about fund managers "distributions" the hard way. A distribution is caused by the fund manager selling a stock or bond position for a profit. When the fund holds stocks and bonds that rise in value, a manager will often sell all or a portion of the position to lock in profits. By doing so, he has also locked in a tax burden for the shareholders. A year-end surprise distribution can saddle an investor with large tax burdens and spoil a perfectly good experience.

Mutual funds are required to pass along most of the realized capital gains to their shareholders that are not offset by losses by the end of the accounting year. When gains outweigh losses, the difference is distributed to the investors.

Investors have no control over when distributions are made and the fund manager only knows to invest the portfolio's assets. A mutual fund manager does not know your aversion to taxes.

Most capital gains distributions are made in November and December, but can really happen at any time during the year. If you own mutual funds through your 401(k) plan, an IRA, or other qualified plan, capital gains are not a concern. Qualified plans are not subject to taxes at year-end and all taxes are deferred until used at retirement.

The most painful tax burden comes when you have just purchased a mutual fund and receive an immediate distribution. Let's say for example you buy ABC Fund with $5,000 in October. The NAV (net asset value, or the price per share for the fund on a given day) is $10, so your $5,000 buys 500 shares. Now assume that the fund distributes $1.00/share in capital gains. You have a tax burden of $500 to report at year-end!

You did not own the fund when these gains were made for the shareholders, but you now have the unenviable position of paying for the manager's transactions because you are a shareholder of record on the day of distributions. Ouch!

An even worse scenario exists if you lose money on a fund in a given year and still get hit with taxable gains from previous purchases by the fund manager. Mutual funds may own stock or bond positions for years before selling them. This can defer tax burdens to shareholders who did not participate in the gains. Among the worst funds to own are the "hot" funds. These funds are likely to unload big gains earned in the previous year just in time for you to buy into the fund and become a shareholder of record.

Some funds are notorious for issuing up to 25% of the investment in capital gains at the end of the accounting year.

Research your funds historic capital gains record. If there is a history of high capital gains distributions, look for an alternative. Don't however choose a fund that is tax efficient and producing 9% when a similar fund makes 17% with more taxes. In that case, you would still come out ahead paying the taxes.

Be aware of the tax bite from mutual funds and you may be able to pocket more money at the end of the year rather than sending it on to Uncle Sam.